What is the best way of assessing how an economy is doing? Economists would tend to look at the big macroeconomic numbers — growth, inflation, productivity, unemployment and the balance of payments. Investors, however, would always concentrate on something more straightforward; the performance of the stock market.

Last week in this column I ranked Britain’s post-war chancellors. One response has been that I was too generous to Sir Geoffrey Howe, awarded first place, and not generous enough to Nigel Lawson, equal fifth. Everybody, it seems, has their favourites.

By far the biggest reaction, though, was to Gordon Brown, ranked second by me. If the economy has been so good under him, the question was, how come the stock market has been so bad? After a week in which the Queen opened the new London Stock Exchange building near St Paul’s cathedral — and switched on The Source, an “artwork reflecting the nature of financial markets in the electronic age” — it is a timely one.

That the stock market in Britain has done badly is not in doubt. On May 1, 1997, the FTSE 100 index stood at 4,445, the All-Share index at 2,139. Last week was not a bad one for shares, but it left the FTSE, which closed on Friday at 4,413, 1% down on its May 1997 level. The All-Share is up, but not by enough to notice, just 3%.

How does that compare with other countries? Germany, once Britain’s economic bogey man, has performed abjectly in recent years. But its main Xetra Dax index is up 13% on May 1997. France, not always thought of as the natural home of the equity investor, has seen a 39% rise, Spain an impressive 61%.

America has been through recession, the bursting of the technology bubble and a wave of corporate scandals, but the Dow Jones industrial average is still 45% up on May 1, 1997 (after Federal Reserve chairman Alan Greenspan’s “irrational exuberance” warning), while the wider S&P 500 is 17% higher. The Australian market, represented by the All-Ordinaries index, is up 41%. One of the few favourable comparisons is with Japan, where the Nikkei is 41% lower than when Brown entered the Treasury.

So why has it been so bad? The simple explanation goes back to the chancellor’s first budget and the decision to abolish the dividend tax credit for pension funds and other financial institutions. The £5 billion annual pension-fund “raid” seemed at the time like an astonishingly clever piece of stealth taxation.

The stock market was rising at the time and appeared to take the tax hit in its stride. Tony Blair, indeed, boasted as much in the Commons (I can’t remember Brown referring to the market much at all and I don’t think it is the first thing he turns to in the morning papers). As for taxpayers, they would not realise they had been fleeced until retirement.

But the pension-fund raid came back to bite Brown sooner than he might have expected. The fall in the stock market brought home the effects of the change and made fund managers reassess long-term equity returns. Combine that with new accounting rules (FRS17) and a re-evaluation by actuaries of future liabilities as a result of greater longevity, and the raid looks like one of the most ill-timed tax changes of recent times. Partly due to Brown’s move, Britain’s occupational pensions — once the envy of the world — have become damaged goods.

That is not the only adverse tax change. Isas were never as good as the Peps that preceded them. Now they offer precious few tax advantages and that, taken with a loss of appetite for equities among small investors, means sales are plummeting. Net sales of Isas in June were 60% down on a year earlier.

John Littlewood, author of the Centre for Policy Studies’ paper, The Stock Market Under Labour, argues that these and other tax changes, together with a wave of new regulations on business, explain why the market has done as badly as it did under old Labour. The historical record is grim. Littlewood calculates that the real (inflation-adjusted) return since 1997 has been negative by more than 10%, compared with minus 7.5% for the 1945-51 Labour government (Attlee), minus 13% for 1964-70 (Wilson) and minus 11.5% for 1974-79 (Wilson-Callaghan). There’s a pattern here, and you don’t need to be Sherlock Holmes to work it out.

But there’s also a puzzle. London is an international market, as are its quoted companies; at least 50% of the earnings of FTSE 100 companies come from overseas. So why does the market appear to behave in such a parochial way?

One answer is that it may not entirely be Brown’s fault. Jason James, an equity strategist at HSBC, points out that London has a high proportion of big stocks, and these are also the ones that have tended to underperform in recent years. The result is that the UK market is a “defensive” market, which failed to rise as much as others during the boom of the late 1990s, and has also failed to bounce so sharply from the lows of last year. The fact is that London shares are a bit dull.

Clive McDonnell, equity strategist at S&P, agrees. The UK market is dominated by lumbering giants, particularly in banking and telecoms. Most notably, it is dominated by Vodafone, a consistent underperformer over the past four years. The “Vodafone effect” has hit London’s performance hard.

But hang on a second, why has Vodafone done so badly? One big reason is that it, together with the other mobile-phone companies, paid a fortune — £22.5 billion — for 3G licences. And who was responsible for that? The Treasury. It all comes back, it seems, to Brown. Perhaps he needs a new target: the stock market.

PS: The National Institute of Economic and Social Research thinks this week’s rate hike from the Bank of England should be half a point, taking rates from 4.5% to 5%, “to influence expectations more forcibly”. Its worry is that, while intelligent readers of the business pages are aware that rates have further to rise, with household debt now past the symbolic £1,000 billion mark — still smaller than Britain’s gross domestic product — many people are taking out loans on unrealistically low assumptions about the future cost of borrowing.

That may be so, but it is unlikely to be reason enough to make the monetary policy committee (MPC) depart from its pattern of quarter-point rate hikes. The latest figures from Nationwide may have house prices up by a surprising 2.1% last month, 20.3% higher than a year ago, but anecdotal and other evidence suggests that the market is starting to cool. One theory is that the strength of prices in the past few months reflects buyers’ desperation to get in and fix their mortgages ahead of further rate rises.

So it looks like a move from 4.5% to 4.75%. Where to then? Charlie Bean, the Bank’s chief economist and an MPC member, presented an upbeat assessment last week, saying “the immediate economic outlook appears brighter than it has done for a while”. Central bankers have suddenly become cheerful (a week earlier Greenspan was talking up the US economy) and when that happens further rate rises cannot be far behind.

Bean emphasised that the Bank had no desire to “clobber” the consumer. What he and the rest of the MPC will want to do, however, is continue the squeeze. That means, it seems, a couple more quarter-point hikes beyond this week. That would take us to February (assuming the Bank sticks to a three-monthly pattern). The MPC could then pause until the general election was safely out of the way before further considering its position. One thing I don’t expect is that it will be in any rush to cut rates once they are safely in “neutral” 5%-5.5% territory.

From The Sunday Times, August 1 2004

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